Friday, October 30, 2009

I tell you honestly, Dear Readers, my afternoon conversation with this genial and intelligent gentleman started unremarkably enough, with a little playful banter in the Twitterverse on this and that. (I called myself a squirrel; he revealed himself to be a slime mold.) But then, something went horribly wrong. After trying to out me with an hurtful photograph of me wearing a hat I haven't owned in years (and an extra 20 pounds I have subsequently shed), he upped his attack on Your Peaceable and Equable Correspondent by trying to pick a fight between yours truly and the fearsome Economics of Contempt.

Now, I have to tell you I consider this very bad form. For one thing, my physical constitution and pugilistic skills are far better suited to being the spotty faced provocateur shouting "Fight! Fight!" from the perimeter of an altercation than being one of the principals. For another, I make it a practice never to get into a fight with a lawyer, unless I can attack him unexpectedly from behind with a lead pipe, preferably in the dark. Furthermore, my unwelcome opponent in this imposed brouhaha was none other than a structured finance lawyer, which every six year old knows is the most dangerous specimen of that deadly species. Heck, I work with structured finance lawyers all the time, which is why I count my fingers every time I shake one's hand and go through six liters a month of hand sanitizer.

So, suffice it to say I clicked through Mr. Waldman's incendiary link to EoC's post with a maximum of trepidation, calculating in advance just how many Russian hookers I might have to ply my opponent with to elicit mercy. But when I arrived, I breathed a virtual sigh of relief, for I discerned my opposite was far less formidable than I feared.

* * *

For one thing, Mr. Contempt's main purpose seems to have been to tie hedge fund principal and commentator Janet Tavakoli to a post and whip her decisively with a wet noodle. This he accomplished admirably, and I have nothing to add to the central thrust of his argument; namely, that Ms Tavakoli overstated her case and overplayed her hand. I also have nothing to add to his speculation on the exact size and nature of Goldman Sach's exposure to AIG in the troubled days of last Fall because, frankly, who the fuck cares?

However, I did note that Mr. C and I do in fact have a basic disagreement about the relative negotiating power at that time of Goldman Sachs and the other AIG counterparties, on the one hand, and the Federal government as owner of AIG, on the other. This, I think, is the core of his argument:

[T]here's no way Goldman would ever have agreed to a "bankruptcy-like settlement" — why would they? As someone who has actually been involved in these kinds of negotiations, let me explain how the AIG/Goldman negotiations would have played out:

AIG: Would you be willing to accept, say, 70 cents on the dollar?Goldman: No.

THE END

Seriously, what could AIG have threatened Goldman with? If they didn't accept a haircut, AIG would file for bankruptcy? Fine, Goldman would've just seized the $7.5 billion in cash collateral, and collected the remaining $2.5 billion from its counterparties on the now-triggered CDS on AIG (on which more below), covering Goldman's full bilateral exposure to AIG. That's what it means to be "hedged."

(This is also why the Fed paid Goldman and the other counterparties 100 cents on the dollar to terminate their CDS contracts with AIG, which this Bloomberg article portrays as some sort of gift to the banks. But the Bloomberg article also relies on the Immaculate Negotiation argument — how, exactly, was the Fed supposed to get the counterparties to agree to take a haircut? The Fed had just demonstrated to the entire world that it wasn't willing to let AIG file for Chapter 11. How do you suppose those negotiations would have gone? The Fed couldn't say, "You can either take a haircut to 70 cents or AIG will file for bankruptcy and you'll only get 50 cents," because everyone knew the Fed wasn't willing to put AIG in bankruptcy.)

He then finesses Tavakoli's argument that Goldman wasn't adequately hedged in such circumstances because AIG's collapse would have engendered widespread systemic disruption and called into question not only the capability of any counterparty to satisfy its obligations under a hedge but also the health and solvency of every participant in the financial system. He does this by saying: 1) Oh yes they could, because the hedges were adequately collateralized, and 2) the potential for total systemic meltdown wasn't the scenario Goldman's CFO was talking about when he said they were adequately hedged. While neatly parrying Ms Tavakoli's principal charge that Goldman lied about its exposure, you must see that this argument almost entirely begs the question.

Mr. C also disagrees that Goldman—and, presumably by extension, the other counterparties to AIG's CDSs—faced any reputational pressure in these negotiations. He writes:

Finally, Tavakoli argues that Goldman's exposure to AIG included "reputation risk." Yes, I'm sure that if AIG had failed, Goldman's reputation for having prudently managed its counterparty risk would've been devastating.

While comprising an admirable example of sarcastic snark, this remark completely mischaracterizes the circumstances surrounding AIG's near death experience last year. All one need do is read a few pages in Andrew Ross Sorkin's hour-by-hour account of the collapse of Lehman Brothers and its aftermath to realize that "reputation risk" encompassed far more than each individual firm's performance of its fiduciary duties alone. More to the point, the CEOs and Boards of the principals involved were very well aware that business—or fiduciary duty, or contract law, or corporate governance—as usual was completely and utterly out the window:

On the surface, Goldman looked like one of AIG's biggest counterparties, but earlier that morning, Goldman's Gary Cohn had boasted internally that the firm had hedged so much of its exposure to AIG that it might actually make $50 million if the company collapsed. The firm's decision to buy insurance in the form of credit default swaps against AIG beginning in late 2007 was starting to seem like a smart investment. The firm had conducted what it internally called a "WOW analysis"—a worst-of-the-worst case scenario—and it was quickly coming true. Even though Goldman had hedged its direct exposure to AIG, [Lloyd] Blankfein appreciated the larger problem: The collateral damage to its other counterparties and the rest of the market could expose the firm to untold billions in crippling losses.1 [emphasis mine]

So, let us not be legalistic, or simplistic, or disingenuous here. Under normal circumstances, I would completely agree with my professional better and, indeed, would and have paid him and his kind mucho dinero to advise me on the way structured finance does and should work when all is right with the world. But virtually nothing was right with the world in the fourth quarter of 2008. Cats laid down with dogs, Paris Hilton matriculated at Oxford, and the thundering hoofbeats of the Four Horsemen could be heard in broad daylight throughout the canyons of Wall Street. The system was on the knife's edge of chaos, and everyone with half a brain—including Goldman Sachs and all of AIG's other counterparties—was very well aware of that.

* * *

So, in the spirit of Mr. Contempt's entertaining post, I would like to propose an alternate transcript for what I think might have occurred during those dark days had I or one of my professional counterparts been in charge of negotiations with Goldman Sachs et al. Normally, I would not reveal a potential negotiating strategy such as this in public without an enormous and frankly obscene fee already marinating nicely in my personal bank vault, but I am feeling inexplicably charitable. Also, it is clear from the underwhelming response to my previous offer of assistance that the Federal government has the backbone and intestinal fortitude of an earthworm, so I'm not worried I am giving away potentially lucrative advice to a client who might actually hire me.

Anyway, let's proceed:

TED, as representative of the Federal government and AIG: Welcome, gentlemen. Please take a seat, and let's begin.

TED: Now, you all realize we are here to resolve the payments which the government of the United States of America, as majority and controlling owner of AIG, proposes to make to each of you to cancel the credit default swaps from AIG you each hold. Before we begin, I would like to make a few opening remarks.

Counterparties: Uh, okay.

TED: First, let me remind you that we are here—and the federal government is here—because our country and indeed the entire world stands upon a knife's edge. We took control and injected tens of billions of dollars of taxpayer money into AIG because we did not want to see this company collapse in an uncontrolled fashion. We believed then, and still believe, that such a collapse would threaten the entire global financial system and indeed the entire global economy. I do not need to explain to you gentlemen the effect such a collapse would have upon each of you, your firms, your employees, and your capital providers. I do not need to explain to you the effect such a collapse would have upon our society, our political system, and indeed the very social order upon which we depend to live our daily lives. We in the government do not have a crystal ball in this regard, but I have been authorized from the very highest level to convey to you that we are scared shitless. You should be too.

Counterparties: [Uncomfortable silence; shifting in seats; coughs]

TED: I have also been authorized to inform you that we are fully aware of the legal rights and fiduciary duties which constrain each of you to do what you think is best for your firms and your stakeholders. Under normal circumstances, we would be entirely supportive of these obligations. However, these are not normal times. Furthermore, and because these are not normal times, I would like to inform you that the government of the United States of America will take an extremely dim view of any individual or institution which chooses to pursue simply its own interest and its own duties without regard for the consequences to the broad economy, this country, and indeed the entire world. This government has a fiduciary duty too, gentlemen, and I am afraid that it trumps yours.

Now, this discussion is a voluntary one. None of you have been compelled to attend this meeting, nor indeed can be compelled to give your acquiescence to what we intend to propose. Some of you here represent companies which are headquartered in foreign countries, and which derive their corporate authority and obligations from the laws of other lands. Be aware that the United States government has already discussed the settlements we will propose here today with ranking representatives of your countries' governments, and we have received their approval and acquiescence.

We previously requested that all of you arrange whatever entities you may need to authorize the corporate and board level approvals your bylaws may require to be standing by, so there is no further delay in resolving these critical issues. The decision point is now, gentlemen. It is today. It is in this very room. The government of the United States of America will brook no further delay.

Counterparties: [Wilting, sweating, uncomfortable silences]

TED: And before we get to brass tacks, gentlemen, allow me to make a personal observation. I have known and admired many of you for many years, and I personally respect the power and dignity of each of your individual institutions.

But I am not your friend today. I am not your fucking friend. As far as you are concerned, you should view me as the Angel of Fucking Death. Because the time has come for each of you to do what is right for the greater good. It is time to think about survival, gentlemen—your own and that of your institutions—both now and in the future. For let me assure you that the decisions you make in this room today will be remembered. They will be remembered, gentlemen, as long as there is a United States of America. And if, God willing, we all come through this terrible crisis to a safer and more stable world, those people who helped us get there will be remembered. And, perhaps more importantly, those people and institutions in this room which did not help us, which put their own narrow personal and corporate interests before the interests of this nation and its people, will be remembered as well.

And let me tell you something, gentlemen, banker to banker: you do not want to be on that list. That list will be a world of pain. That list will be Death. That list will be populated with people and institutions which will have the full weight, power, and authority of the government of the United States of America brought down on them in the most thorough, comprehensive, and legal way you could possibly imagine. That list will be the proctology exam from Hell, and it will never end.

So, having set the stage, you should each find before you a term sheet with a proposed haircut for the AIG CDSs your institution currently holds. In each case, this is the government's best and final offer. I would like each of you to retire from this room with your team, talk it over amongst yourselves and with your Board, and bring the signed term sheets indicating your firm's acceptance of these terms back to me in this room. You have one hour.

Any questions? No?

Then I thank you for your attention. You may leave.

* * *

Would this approach have recovered all 40% of the original discount AIG tried to obtain? Probably not. Tough talk or no, the assembled banks would balk at completely unreasonable demands by the government. And if they balked, they would have time to mobilize their vast lobbying apparatus to try to counteract the government's bid through Congress. Delay would be deadly. You could not allow the counterparties to regroup, or even collect their thoughts.

You've gotta drop a daisy cutter on their ass, and roll the tanks in immediately thereafter. Shock and awe, baby.

But you know why this could work? Because all those bank CEOs and CFOs would look across the table at me and realize: this guy is a mercenary, heartless, psychopathic bastard just like me. And he is getting paid to run a Roto Rooter up my ass. Let's get it over with, and then I can plan my revenge on this bastard later on.